Keeping Exempt Organizations Exempt
By Marshall A. Glick
Edited by Barbara Kate Repa
Category: Business Organizations
At some point in their careers, many attorneys are called on to assist their clients, friends, or some local volunteer group by securing tax-exempt charitable status under IRC §501(c)(3). Although many are willing to donate their time occasionally to a worthwhile cause, few have much experience in nonprofit law. Fewer still have more than a rudimentary understanding of the requirements of the formation and exemption process. And many practitioners simply do not realize that, with their well-meaning actions, they are cracking open a Pandora's Box of complex tax and legal issues that could leave them vulnerable to creating unwitting errors and omissions.
Consider the following scenario: You formed a nonprofit organization, XYZ Charity, for a client interested in benefiting low-income Los Angeles residents. You struggled through the arduous and time-consuming process of filing articles of incorporation with the secretary of state, Form 1023 with the IRS, and Form 3500 with the Franchise Tax Board (FTB)-all of which are required to attain XYZ's exempt status on the federal and state levels.
After responding to some IRS questions, XYZ's officers eventually received determination letters from the IRS and the FTB conferring tax-exempt status on the organization. You and your client were justifiably delighted. Since then, XYZ has been operating in the public interest, and the targeted low-income community in Los Angeles has been served well. And XYZ has also received substantial public donations over the years.
You blithely assume that all is well. But that assumption is shattered by a frantic call from your client informing you that the IRS and the FTB are threatening to revoke XYZ's exempt status-and that the California Registry of Charitable Trusts (the Registry), a division of the California Department of Justice, has kicked off an investigation. The exempt status may be revoked because of a number of alleged compliance failures, including the charity's failure to file forms with the Registry, the IRS, and the FTB.
To make matters even more grim, XYZ's president says he has just received an order to cease and desist from all fund-raising from the Charitable Services Section of the Los Angeles Police Commission, citing the organization's failure to file additional paperwork before beginning its activities in the city.
A chill runs down your spine as you try to recall what instructions you gave back in those hopeful days of seeking nonprofit status for XYZ. When the file is retrieved, you are unable to find any notes or copies of any correspondence about any of these matters.
Ounces of Prevention
The hope is that this nightmare scenario will never haunt those of you who form and advise private foundations and public charities. Complying with all governmental filing requirements is essential to retain exempt status and avoid severe penalties and other adverse consequences, both to the attorney who is involved and to the exempt organization.
In truth, attaining federal and state tax-exempt status reflects only the tip of the iceberg of compliance requirements. After that, a nonprofit organization must also satisfy a number of additional federal, state, and local requirements-most of which are ongoing from year to year.
As part of the formation process, inform the client of all applicable federal, state, and local filing and compliance requirements. Though there may be no legal obligation to continue rendering services to an exempt organization after it is formed, the standard of practice in nonprofit law requires attorneys to inform their clients about the additional compliance requirements. And for evidentiary purposes, it is always best to give these instructions in writing. Failing to provide such basic information may leave you open to a legal malpractice action based on errors and omissions.
A Look at the Most-Often Overlooked
The adage that an ounce of prevention is worth a pound of cure is particularly relevant in nonprofit law. After the IRS, Registry, or FTB begins an investigation of alleged compliance failures, it can be very difficult, time-consuming, and costly to backtrack and cure any deficiencies. The most significant-and most-often overlooked-requirements for maintaining a charity's continuing exempt status are highlighted here.
File Form CT-1 with the Registry. Most nonprofit organizations, including corporations, associations, and trusts holding assets for charitable purposes or doing business in California and carrying out activities for the benefit of the public, are required to file a completed Form CT-1 with the Registry. Only corporations organized primarily as hospitals, schools, or religious organizations are exempt from this requirement. Gov't C §12583.
Form CT-1 must be filed as soon as possible after the IRS issues the determination letter conferring exempt status-along with a copy of that letter as an exhibit, as well as a copy of the articles of incorporation and bylaws. The deadline for filing is six months after the charity receives assets such as cash or property donations. Although the form states that the charity's financial statements for its most recently completed accounting period must be provided, newly formed charities usually have no such prior operating experience. In such cases, the Registry may delay processing the registration until a copy of Form 990, 990PF, or 990EZ (all of which are filed with the IRS) or Form 199 (filed with the FTB) is submitted.
After receiving Form CT-1, the Registry will issue a state charity number. Many prospective donors may ask an organization for this number before agreeing to make a donation to it.
File Form RRF-1 with the Registry annually. All charitable nonprofit corporations, associations, or trustees holding assets for charitable purposes that are required to register with the Registry are also required to file Form RRF-1 each year. Organizations must meet this requirement even though they did not receive any assets, have not filed Form 990 with the IRS, or are on extended reporting as described below. In addition, they must attach a copy of the most recent financial reporting forms-Form 990 and Form 199-as they become available.
A few California nonprofits are exempt from this filing requirement. They include governmental agencies; religious corporations; certain cemetery corporations; political committees; charitable corporations operated primarily as religious organizations, educational institutions, or hospitals; certain licensed health care service plans; and corporate trustees subject to the jurisdiction of the California Superintendent of Banks.
Form RRF-1 must be filed within four months and 15 days after the close of the organization's accounting period-either calendar or fiscal year-end. For example, a calendar year organization must file no later than May 15 of the following year. Although the regulations require filing for the most recent full accounting period, new organizations should also file within four months and 15 days of their initial accounting period rather than risk severe penalties for filing late.
According to legal strictures, no extensions are allowed for any Form RRF-1 filing, regardless of the circumstances. Failing to file on time each year-even for years in which there have been no charitable receipts and no assets-may result in the FTB revoking the exempt status and assessing a possible minimum tax of $800, interest, fines, and filing penalties. Gov't C §12586.1. However, despite its own prohibition on issuing extensions, the Registry is currently processing late Form RRF-1s when there is good cause and an explanation of why the filing was late.
Though most nonprofit organizations normally need not pay a filing fee, a $25 fee is required for accounting periods in which total assets exceed $100,000.
File Form 990 with the IRS annually. If the nonprofit organization is other than a church, a state institution, an instrumentality of the United States, a stock bonus, a pension or profit-sharing trust, or certain other excepted entity, and normally has gross receipts of more than $25,000, it must file Form 990, Return of Organization Exempt From Income Tax, or the short version Form 990-EZ, each year with the IRS. Private foundations file Form 990-PF.
An organization's gross receipts are defined as the total amount received from all sources during its annual accounting period without subtracting any costs or expenses. Organizations with gross receipts of more than $25,000 but less than $100,000 and total assets of less than $250,000 at the end of their accounting periods qualify to file the much less onerous Form 990-EZ.
Organizations that receive a Form 990 package, which the IRS generally mails to nonprofits as a matter of course, should file the return even if they are not required to do so. They should also check the box in the heading of the form to indicate that gross receipts are normally not more than $25,000.
There is no filing fee for any of the 990-derived forms.
The deadline for filing Form 990 is five months and 15 days after the end of the organization's accounting period-confusingly, one month longer than the due date for Form RRF-1. And unlike Form RRF-1, the due date for Form 990 may be extended. If the due date falls on a weekend or legal holiday, the filing date is extended until the next business day.
The IRS grants an automatic three-month extension to those who file Form 8868, Application for Extension of Time to File an Exempt Organization Return, prior to the original due date. After that, Form 8868 may also be used to apply for one additional three-month extension if the original extension was insufficient and there is a showing of reasonable cause for the additional extension.
A common omission in filing is the inadvertent failure to attach Schedule A, Organizations Exempt Under Section 501(c)(3). Schedule A must be filed with Form 990 or Form 990-EZ if a 501(c)(3) organization is not a private foundation and has gross receipts exceeding $25,000 for the reporting period.
Failing to file Form 990 and Schedule A on time, or filing incomplete or inaccurate documents, may result in a fine of $20 a day, not to exceed the lesser of $10,000 or 5 percent of the gross receipts of the organization for the reporting year. For larger organizations, with annual gross receipts exceeding $1,000,000, the penalty for late, incomplete, or inaccurate filing is $100 a day-with a maximum penalty of $50,000 for any one return.
Form 990 is lengthy and complex, and an organization's accountants might be better equipped to prepare it. The attorney's responsibility is to inform the client of the Form 990 filing requirement and to clarify who will have the responsibility for preparing and filing this form in a timely manner.
File Form 199 with the Franchise Tax Board. Form 199, California Exempt Organization Annual Information Return, is filed with the FTB and is the state equivalent of IRS Form 990. It differs, however, from the federal form in that there is a $10 filing fee-which is increased to $25 if Form 199 is not filed by the original due date-for organizations other than those that are exclusively religious, exclusively charitable, or formed for preventing cruelty to children or animals.
Except for private foundations, organizations with gross receipts that normally do not exceed $25,000 are not required to file this form. Other organizations exempt from filing include exclusively religious organizations; state-controlled organizations; certain political organizations; qualified state tuition programs; education IRAs; and most stock bonus, pension, or profit-sharing trusts.
Like Form 990, Form 199 must also be filed no later than five months and 15 days after the end of the organization's accounting period. If it is not filed by its original due date, and if the organization was in good standing in California on the original filing date, an automatic extension of up to seven months is provided. There is no need to apply for the extension.
Organizations that fail to file the return by its original or extended due date may be required to pay a penalty of $5 a month, not to exceed $40, until the return is filed. The FTB may waive the penalty on a showing of good cause for late filing. Form 199 is not nearly as formidable as Form 990, but the client's accountant may still be the person who is best qualified to prepare it.
File Form 70-20.04, Notice of Intention. In XYZ's haunting tale of noncompliance, the charity also failed to file a Form 70-20.04, Notice of Intention, with the Charitable Services Section of the Los Angeles Police Commission.
All charities that wish to solicit public donations in Los Angeles are required to file this form at least 15 days before the start of each fund-raising campaign or special event. A Report of Results of Activity must also be filed within 30 days after the special fund-raising event. The report discloses receipts, expenditures, and distribution of net proceeds from the public solicitation. Los Angeles Mun C ch IV, art 4, §§44.00-44.15.
Check the local municipal ordinances for similar filing requirements for organizations operating in other locales.
Resurrecting Fallen Organizations
All may not be lost for nonprofit organizations that fail to comply or fall out of compliance. The facts and circumstances of each case usually determine whether exempt status can be preserved or resurrected. Absent actual fraud, gross negligence, or willful misappropriation of charitable funds, many organizations can be resuscitated and their exempt status retained through candid disclosures to the IRS, the FTB, and the Registry.
Retaining exempt status often depends on whether or not the organization is voluntarily willing to come forward with an admission of its prior compliance failures. Even clients who have neglected or repeatedly failed to file the requisite forms with the requisite authorities will rarely lose exempt status, as long as the omissions are voluntarily and fully disclosed to the proper agencies. However, those agencies may impose substantial penalties for late filing.
The problem most frequently encountered is the failure to maintain complete and accurate records of all expenditures and all revenue, such as donations and other income. At the outset, inform the client in writing of the importance of good, complete, and accurate record keeping and of the need for timely and complete filings on the federal, state, and local levels.
Forms and Facts
Where to get the information you need.
Forms CT-1 and RRF-1
Obtain these forms, along with instructions for completing them, by calling the Registry at 916/323-0786 or from its website at www.caag.state.ca.us/charities under the subcategory Forms on the home page.
Forms 990, 990-EZ, 990-PF, 8868, and Schedule A
Get these forms from the IRS by calling 800/829-3676 or downloading them from the website at www.irs.gov, in the Forms and Publications section.
This form is available from the California Franchise Tax Board by calling 800/852-5711 or from its website at www.ftb.ca.gov under the heading All Forms and Publications.
Marshall A. Glick (firstname.lastname@example.org; www.glicklaw.com) practices nonprofit law in Encino, California. He is the author of Forming the Exempt Organization (CCH, Inc., 2002).